Real estate is something you hear a lot about these days. Rental properties are a popular method for investing in real estate. Rental property investing is not something available to many people.
- First, it's not passive.
- Second, it takes some cash to get started.
There are ways to get into real estate that are passive and don't take large amounts of cash to get started. REIT investing is the easiest way to start investing in real estate. In today's post, we're going to introduce you to everything you need to know about REIT investing.
We've written about how to get started investing. We've also written about a couple of the options available in private REITs. I'll highlight those two again in today's post as well. We think they represent the best options out there. I'll tell you what we like about each and why we have a favorite.
For centuries, people have built fortunes with real estate. University endowments like Harvard, Princeton, and Yale have large percentages of their portfolios in private real estate deals. Because of their size and the money they can bring to the table, many of these endowments get the real estate developers to design programs specifically for them.
Of course, individual investors don't have the cash or clout to do that. There are, however, some good ways to invest in real estate. We think investors should at least consider having real estate as part of a well-diversified portfolio.
Types of Real Estate
There are many types of real estate available for investment. You are likely familiar with most of them. Here's a shortlist and a brief description of each.
As the name suggests, residential properties are primary residences where people live. These can be single-family homes, condominiums, or townhouses. Most of us don't view our homes as investments.
However, for many, it's the number one way they've increased their net worth. Depending on the area in which you live, our homes are usually our most significant asset.
In a high cost of living area, homes often appreciate at a much higher rate. Jobs are plentiful. Incomes are higher. Demand for employment and housing is high, which increases real estate values. It's basic economics. The demand for houses is greater than the supply.
Most buy houses with a mortgage. As time goes on, the mortgage balance decreases. As the mortgage balance decreased and the house's value increases, the equity (the amount you keep if you sell the house) increases. Many people start their real estate investing by using the equity in their current home to buy a second house. They would then rent their original house out as an investment.
This is a higher risk way to buy real estate. Often, the equity in the first house isn't enough to buy the second house for cash. So they end up with two mortgages. If the rent doesn't cover the mortgage, you find yourself in a negative cash flow situation, meaning rather than the rent-paying the mortgage, taxes, and insurance, you have to pull money out of your pocket to make up the shortfall. That's not a situation that makes sense for most.
Having the cash for a downpayment or paying cash for a rental property is the biggest deterrent to getting into rental properties. I would never advise buying rental properties that have negative cash flow. It defeats the purposes of the investment.
Commercial properties are things like strip centers, multi-family housing units, office buildings, things like that. It's the next step up from investing in residences. Appropriately done, investing in commercial properties can be safer and more lucrative. Of course, you know the problem with it. The costs of entry are significantly higher than that of single-family homes bought as rental properties.
If you can't come up with the cash for a down payment on a home rental, you're certainly not going to be able to find the money necessary for a commercial property. Because these properties are higher-priced and more complex, it's also unlikely you'll find a lender to finance them for you. These deals are left to professional real estate investors, hedge funds, and private equity funds.
Tenants of commercial properties are businesses. Property managers handle the leasing, maintenance, and upkeep of the properties, adding additional investment expenses. Leases on commercial properties are usually longer-term – five years or more. Tenants typically have a track record property managers can examine to determine whether they will be good tenants. Rents tend to be more stable in commercial properties. However, overdevelopment leads to higher supply and less room for negotiating leases. That's good for tenants. Not so much for property owners.
Smaller investors may invest in these properties via a mutual fund or private equity with lower minimum investments. High fees are the most significant deterrent to good investment returns. Be sure to look at the fund's fee structure and track record before investing in commercial properties.
A type of commercial property, retail properties might come in strip malls or smaller shopping centers with several retail stores. They may have anchor tenants like grocery stores (think Kroger, Giant, Safeway) with high traffic to draw people into the center. Anchor tenants usually have triple net leases. That means they pay their share of the property taxes, insurance, and the center's maintenance costs. They're also responsible for any repairs necessary on their part of the center.
You see why these are called anchor tenants. They anchor the center and take on more of the costs for the owners. Depending on the size of the shopping center, some centers have multiple anchor tenants. The more anchor tenants, the higher the rent for the other storefronts. Anchor tenants draw traffic. Smaller tenants pay a higher price to get that traffic. It doesn't mean they will come to their stores. But it brings more eyes to their storefronts.
Once again, these are not investments available to most individuals. Limited partnerships, hedge funds, private equity funds, and corporations are the primary investors in these types of properties.
Mixed-use properties are becoming one of the more popular types of commercial real estate investments. As the name suggests, mixed-use properties consist of several kinds of tenants. There may be a retail section, commercial office space, a hotel, restaurants, apartments, and condos for housing. The area where we live has many mixed-use properties.
The concept of a town center is a perfect example of mixed-use properties. The town center concept is becoming popular across the country. The idea is to have everything you need within walking distance of your home. In other words, you live in a walkable neighborhood. Density is the name of the game for mixed-use properties.
Town centers are often built around hubs of public transportation like metro trains or bus lines. One selling point is that these centers reduce the carbon footprint. The theory is that people won't drive their cars as much or, ideally, at all. In my area, that has yet to become a reality. On the contrary, there is more traffic than ever in our area.
As an investment, though, mixed-use properties can be very profitable. Once again, these are for the “big boys” of the investment world. Developers, private equity, fund managers, and corporations are the primary investors in these properties. Very few offer opportunities for smaller investors.
How, then, do smaller investors get into real estate?
REIT investing allows smaller investors to get into these properties without a significant investment. What is a Reit? Let's take a short walk back in history to see how they started.
Investopedia describes how Reits started:
“Congress established real estate investment trusts (REITs) in 1960 as an amendment to the Cigar Excise Tax Extension of 1960. The provision allows individual investors to buy shares in commercial real estate portfolios that receive income from various properties. Properties included in a REIT portfolio may include apartment complexes, data centers, health care facilities, hotels, infrastructure—in the form of fiber cables, cell towers, and energy pipelines—office buildings, retail centers, self-storage, timberland, and warehouses.”
I won't go into the entire discussion of the requirements to call yourself a REIT. The Investopedia article does a great job with that if you want to take a deeper dive. The bottom line – REITs allow the “little guy” to invest in the same kinds of properties as the “big boys” always have.
You can do REIT investing via publically traded REITs via mutual funds or ETFs. You would buy and sell shares of these REITs like stocks, ETFs, or mutual funds. There are also publically non-trade REITs. These are less liquid than publically traded REITs. They don't trade on national exchanges like mutual funds and ETFs. As such, they are not subject to the kinds of market fluctuations as publically traded REITs.
Types of REIT real estate
One of the decisions investors need to make is not only what kind of REIT they should buy. REITs can invest in all of the types of properties we described earlier. Do you want to invest in a REIT that acquires residential homes? Commercial properties? Mixed-use? Some REITs specialize in one or the other of these types of properties. Some invest in more than one. Others invest in multiple types of properties, either in a specific region or nationwide. There are international REITs that invest in properties inside and outside the U.S.
Why real estate?
When investing in anything, whether it's REIT investing, stocks, bonds, or mutual funds, the most important decision is to know the purpose of the money. What is the long-term goal for the funds? How does real estate fit into that plan? Do I want an income from the real estate? Growth? Or a combination?
There are two reasons to invest in real estate. The first is to have the money grow. The second is for income. The requirements of a publicly-traded REIT are such that their primary benefit comes in the form of income. These REITs have to distribute up to 90% of their taxable income every year via dividends paid to shareholders. That income is taxable at ordinary income rates. Unlike qualified dividends from many stocks, there is no preferential taxation for REIT dividends.
REITs do, however, often have higher dividends than many stocks. If you're looking for growth in your real estate investments, publically traded REITs are not the best option.
REIT Investing for Growth
If publically traded REITs are for income, how do we invest in REITs for growth? The short answer is private equity.
In the past, private equity investments were only available to high-net-worth investors or accredited investors.
Accredited investors are those with at least $200,000 in income ($300,000 joint) or a $1,000,00 net worth (exclusive of residence). That cuts off the vast majority of the investing public. Only the 1% get into the game. That's been the biggest complaint and downside of private equity funds.
The other knock-on these funds are the high fees. In the beginning, they had what's called the two and twenty fee structure. That meant investors paid a management fee of 2%. If the fund made profits, management took 20% of the profit. Most people feel those fees are expensive. Competition and public pressure have brought down these fees. They are still among the highest in the industry.
Private equity funds are pooled investment funds, not investment companies. As such, they don't have to register as investment companies with the SEC. They get what's called an exempt status under the SEC Private Advisor Rule. In many ways, this is an advantage to the fund and its investors. Complying with the investment company rules is costly and time-consuming. Reporting requirements, in particular, are eased under the Private Advisor Rule.
Crowdfunded real estate funds
In recent years, crowdfunding has made its way to real estate investing. Crowdfunded REITs are most often offered in private funds, meaning they are not publicly traded. These newer funds register with the SEC as exempt funds, usually under the SEC's Regulation Crowdfunding. Crowdfunding in real estate, like with individual or small business crowdfunding, allows smaller investors into an investment space that hasn't been available to them in the past.
Crowdfunding provides investors with smaller amounts of money to invest in things commonly only available to the wealthy. It's been a disruptive force in the investment and small business communities. It offers a method of fundraising that can bypass big banks with high rates and fees. In the end, the winners are we consumers. In crowdfunded real estate, non-accredited investors can play in the same playground as the big boys.
Growth vs. income
We reviewed our top two choices in the crowdfunding real estate place in an earlier post. The two funds considered were Fundrise and DiversyFund. These funds offer investors a way to invest in quality real estate with a minimum investment of $500.00.
If you're looking to invest in real estate for growth, DiveryFund is the clear choice in my view. Here is a summary of the reasons.
- No platform fees – Management and administrative expenses eat away at returns. There are no platform fees in the DiversyFund Growth Fund.
- Vertically integrated – Being vertically integrated means they do everything in-house. They don't pay brokers, developers, or contractors. They manage the properties themselves. This keeps costs down.
- Multi-family properties – They only buy multi-family properties like apartments, condos, and townhouses. They look for properties that need some work and have high occupancy rates, so cash flow is good. They make improvements to them to increase the rent for new tenants and when leases renew. Improved properties mean better cash flow. Better cash flow leads to a higher selling price.
- Geographic diversity – Their technology allows them to search the country for exactly the types of properties they target. They aren't looking for just any property. They walk away from far more than they buy. Sticking to this strategy improves their chances of increased value when properties get sold.
- Owners are investors – Unlike many real estate funds, the owners of DiversyFund invest their own money in the fund's properties. With their own money at risk, they take special care to do the investing right. And get this. They don't take profits before their investors. That's right. When you get paid, they get paid. That's a rarity in the real estate world.
If you want a REIT that invests in growth, we think the DiversyFund Growth Fund is the right choice.
For accredited investors
If you happen to be one of the fortunate few accredited investors (good for you), DiversyFund has something special for you, too – their Series A investment. Not familiar with Series A investing? Typically, startup companies use Series A financing to raise money in their early stages of growth. First, it's friends and family. Then angel investors. Series A is often the third leg. Venture capital (VC) firms often get into the game at the Series A level. VC money usually comes at a price. What price? A higher percentage of ownership and, quite often, a seat on the board.
VC investors aren't looking for cash flow. They want to get paid when the company goes public or raises money in the next round (Series B or Series C). It's a common practice for startups to raise capital. Negotiations are often fierce. Owners want to get the investment and maintain control. VC investors want to invest the money with a more significant say in how the company operates. Their goal is to get 5x or 10x back on their investment.
DiversyFund Seris A
Like with their growth REIT, DiversyFund has taken a different approach to Series A. Yes, you have to be an accredited investor. That's not their rule. That rule comes from the regulators. Here's how they're different.
Their goal is to raise $6 million in their Series A round. To date, they've raised over $5 million from 84 investors. Doing the math, that's an average investment of $59,523. How do they do that? First, they're managing the offering themselves. They aren't paying an investment firm to do it. Plus, the minimum investment is $25,000. As VC investments go, that's a very low minimum to start. Series A investors get secured convertible notes. The notes are secured by real estate assets the company owns. Notes are a two-year term with a 12% annual interest. Investors can take a cash interest or reinvest it.
At the end of two years, their plan is to a Series B round of financing. Investors in the Series A round can roll their money into the Series B at a 20% discount. That's a highly competitive offer. The ultimate goal is either an IPO or a Series C round of financing that would return Series A investors 10x their original investment.
What about risk?
Is this a riskier investment? Absolutely. Is it less risky than other Series A investments? Maybe. The fact that the investment is for accredited investors says the investment is riskier. Accredited investors are, supposedly, more sophisticated investors who have a better understanding of investment risk. That point is arguable.
Everyone needs to determine what level of risk they're willing to take. I can tell you this. Very few VC investments have quality real estate securing their notes. If you're an accredited investor wanting to get into a real estate company for a smaller initial investment, DiversyFund's Series A is worthy of your consideration.
Here are more details from DiversyFund to explain them further.
Well, there you have it – the REIT investing basics and the various ways to get started in real estate. REITs come in a variety of shapes and sizes. If you're retired and looking for a good income investment, publically traded REITs may be the right choice.
If you're looking for growth in your real estate, residential, commercial, and mixed-use properties are good options. The barrier to entry to those is high. You have to be an accredited investor with loads of cash. As we said early on, real estate is an asset that many wealthy people have built their fortunes. As the saying goes, you have to have money to make money.
Crowdfunded REITs offer an entry point for investors who either don't have the cash or don't want to risk the money in these types of real estate. With a $500 minimum investment, crowdfunded REITs may be an option to consider. If you're an accredited investor who's always wanted to invest in a Series A or other VC type of investment, the DviersyFund Series A investment with it's secured convertible notes and $25,000 minimum may make sense.
REIT investing doesn't have to be complicated. I hope we've given you enough good information to decide if and how is the best way for you to start.
Let us know what you think in the comments below.